Financial Reporting and Analysis Chapter 7 Solutions Receivables Exercises Exercises E7-1.Account analysis (AICPA adapted) To find the amount of gross sales, start by determining credit sales. We can do this with the accounts receivable T-account below. Accounts Receivable Beginning AR $80,000 $1,000 Accounts written off Credit sales X 35,000 Cash collected Ending AR $74,000 $80,000 + X - $1,000 - $35,000 = $74,000 X = $30,000 = credit sales Now that we know the amount of credit sales, we can add cash sales to this amount to find gross sales. Credit sales $30,000 Cash sales 30,000 Gross sales $60,000 E7-2.Account analysis (AICPA adapted)
Transcript
Financial Reporting and Analysis
Chapter 7 SolutionsReceivablesExercises
ExercisesE7-1.Account analysis
(AICPA adapted)
To find the amount of gross sales, start by determining credit sales. We can do this with the accounts receivable T-account below.
(Note to instructor: Students should be aware that the account titles allowance for uncollectibles and allowance for doubtful accounts are used interchangeably in practice.
To find the amount of accounts receivable before the allowance, we need to recreate the journal entries that affected accounts receivable and the allowance for doubtful accounts to record bad debt expense. Since we know that $10,000 was written off as uncollectible from accounts receivable, the first journal entry is:
DR Allowance for doubtful accounts $10,000CRÊAccounts receivable $10,000
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The entry for $40,000 of bad debt expense would be:
DR Bad debt expense $40,000CRÊAllowance for doubtful accounts $40,000
Based on the two entries above, the balance in the allowance for doubtful accounts at the end of the year was $30,000. The amount of accounts receivable before the allowance for doubtful accounts that should appear on the balance sheet is calculated as:
Net accounts receivable $250,000Allowance for doubtful accounts 30,000Gross accounts receivable $280,000
E7-3.Ratio effects of write-offs (AICPA adapted)
1. ÊThe current ratio does not change as a result of the write-off to the allowance account. Accounts receivable and its contra account, allowance for doubtful accounts are reduced by the same amount. Thus, accounts receivable (net), which is the number used in computing the current ratio, does not change. b. X equals Y
2. ÊThe accounts receivable (net) balance does not change as a result of the write-off to the allowance account. When the $100 account is written off, accounts receivable and allowance for doubtful accounts are reduced by the same amount. Thus net receivables is the same before and after the write-off. Further write-offs to the allowance account will increase the allowance account and decrease accounts receivable (net). b. X equals Y
3. ÊGross accounts receivable will be lower after the write-off than before the write-off because accounts receivable is credited for the $100 uncollectible account that is written-off. Gross accounts receivable is the amount of receivables before subtracting the allowance so there is no change. a. X greater than Y
E7-4.Bad debt expense(AICPA adapted)
We can determine the amount of bad debt expense in 1998 by first examining the allowance for doubtful accounts.
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Allowance for Doubtful Accounts
$1,200 Beginning balance1,000 Provision for bad debts
Accounts written off $1,600X Additional provision for bad debts$1,100 Ending Balance
Solving for the additional provision for bad debts:$1,200 + $1,000 - $1,600 + X = $1,100 X = $500
Total bad debt expense for the year ended December 31, 1998 should be:
Provision for bad debts $1,000Additional provision for bad debts 500Total bad debt expense $1,500
E7-5.Amortization table(AICPA adapted)
The amortization table for Lake Company appears below.
Requirement 2:The account increases the carrying amount of the note receivable which will ultimately total $100,000.
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Financial Reporting and Analysis
Chapter 7 SolutionsReceivables
Problems
ProblemsP7-1. Allowance for uncollectibles
Requirement 1:Based on the aging schedule, the ending balance in the allowance for doubtful accounts is calculated as follows:
Expected DollarAge of Receivables Amount Bad Debt Amount
Zero to 30 days old $30,000 5% $1,50031 days to 90 days old 10,000 11% 1,100Over 90 days old 5,000 30% 1,500
$4,100
The company needs to record an additional bad debt expense of $600 ($4,100 - $3,500) to increase the allowance balance to $4,100.
December 31, 1998DR Bad debt expense $600
CRÊAllowance for uncollectibles $600
Cash Flow Net from
Assets Liabilities Income OperationsDirection of effect - NE - NEDollar amount of effect 600 600
The journal entries for the other transactions are provided below:
January 1, 1999No journal entry is recorded since the ultimate resolution of the account receivable is still uncertain.
March 1, 1999DR Allowance for uncollectibles $800
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CRÊAccounts receivable $800
40% of $2,000 is written-off as uncollectible.
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Cash Flow Net from
Assets Liabilities Income OperationsDirection of effect NE NE NE NEDollar amount of effect
Since write-offs are typically realizations of events that have already been anticipated (through the bad debt provision), they do not affect the assets or the net income.
May 7, 1999DR Cash $1,200
CRÊAccounts receivable $1,200
Cash Flow Net from
Assets Liabilities Income OperationsDirection of effect NE NE NE +Dollar amount of effect 1,200
Requirement 2:Based on the aging schedule, the ending balance in the allowance for doubtful accounts is calculated as follows:
Expected DollarAge of Receivables Amount Bad Debt Amount
Zero to 30 days old $30,000 3% $ 90031 days to 90 days old 10,000 8% 800Over 90 days old 5,000 22% 1,100
$2,800
Since the company has a larger balance than what is required by the aging schedule, the company should decrease its bad debt expense by $700 ($3,500 - $2,800).
December 31, 1998DR Allowance for uncollectibles $700
CRÊBad debt expense $700
Cash Flow Net from
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Assets Liabilities Income OperationsDirection of effect + NE + NEDollar amount of effect 700 700The other journal entries do not change from Requirement 1.
P7-2. Account analysis(AICPA adapted)
Start with the 1999 allowance for doubtful accounts:
1999Allowance for Doubtful Accounts
$ Beginning balanceAccounts written-off $50
X Bad debt expense
$ Ending balance
Solving for X:$47 - $50 + X = $30X = $33
Now divide bad debt expense by charge sales.$33/$1,100Bad debt expense = 3% of charge sales
Since we know that there has been no change in method during the three years shown, we can apply this ratio to 1998.
1998Allowance for Doubtful Accounts
Y Beginning balanceAccounts written-off $2
X Bad debt expense
$ Ending balanceEnding Balance
We can find X because we know that it is 3% of charge sales.$900 X .03 = $27
Now plug bad debt expense into the equation:Y + $27 - $2 = $47Y = $22
The 1998 beginning balance in the allowance for doubtful accounts is $22,000.
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P7-3. Comprehensive receivables and allowance analysis
Requirement 1:
To record the credit sales for the year.
DR Accounts receivable $100,000CRÊSales revenue $100,000
To record the collections for the year.DR Cash $92,000
CRÊAccounts receivable $92,000
Bad debts written off during the year.DR Allowance for uncollectibles $9,000
CRÊAccounts receivable $9,000
Accounts receivable DR CRBeginning balance $20,000Credit sales 100,000Cash collections $92,000 Bad debts written-off ______ 9,000Ending balance $19,000
Expected Bad DebtsAging Information Book Value ÊÊ%ÊÊ ÊÊ$ÊÊ> 90 days past due $2,000 30% 600 31Ð90 days past due 7,000 20% 1,400 Current (plug number) 10,000 10% 1,000Total from gross A/R T-account $19,000 $3,000
Allowance for uncollectibles DR CRBeginning balance $2,000 Bad debt expense (plug number) 10,000 Bad debts written-off $9,000 _____Ending balance (from aging schedule) $3,000
To record entry for bad debt expense (from the allowance account)DR Bad debt expense $10,000
Requirement 3: The bad debt expense for 1998 can be broken down into the following three components:
Breakdown of bad debt expenseCurrent yearÕs actual bad debts
(bad debts written off from this yearÕs sales)$ 5,000
Current yearÕs expected bad debts (ending balance in the allowance account) 3,000
Excess of 1997Õs actual over expected bad debts ($4,000 minus $2,000) 2,000
$10,000
The learning objective for this requirement is to enable students to understand how and when expected and realized bad debts affect the bad debt expense. One component arises from sales made and settled during the current year. Another component comprises the expected bad debts due to sales made during the current year that are yet to be settled. The final component is the result of an error made in the previous yearÕs estimate of bad debts on outstanding accounts receivable.
A second aspect of the problem is to highlight how much of the information is publicly available in the financial statements. This problem is specifically constructed with breakdowns provided on collections and bad debts grouped by the year of sale. However, in a typical annual report, it will not be possible to see these components without additional disclosures in the management discussion and analysis section.
DR CRAllowance for doubtful accountsBeginning balance 1995 $ 35,000 Provision for doubtful accounts 150,631 Bad debts written off (plug number) $105,771 Ending balance 1995 $ 79,860
Gross accounts receivableBeginning balance 1995 $ 210,758 Revenues 2,218,139 Bad debts written off (from ADA) $105,771 Cash collected (plug number) 1,997,897 Ending balance 1995 $ 325,229
DR Accounts receivable $2,218,139 CRÊRevenues $2,218,139
DR Provision for doubtful accounts $150,631 CRÊAllowance for doubtful accounts $150,631
DR Allowance for doubtful accounts $105,771 CRÊAccounts receivable $105,771
DR Cash $1,997,897CRÊAccounts receivable $1,997,897
Journal Entries for 1996
DR CRAllowance for doubtful accountsBeginning balance 1996 $ 79,860Provision for doubtful accounts 20,585Bad debts written off (plug number) 0Ending balance 1996 $100,445
Gross accounts receivableBeginning balance 1996 $ 325,229 Revenues 2,175,475 Bad debts written off (from ADA) 0Cash collected (plug number) $2,146,981
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Ending balance 1996 $ 353,723
DR Accounts receivable $2,175,475CRÊRevenues $2,175,475
DR Provision for doubtful accounts $20,585 CRÊAllowance for doubtful accounts $20,585
DR Allowance for doubtful accounts 0CRÊAccounts receivable 0
DR Cash $2,146,981CRÊAccounts receivable $2,146,981
Requirement 2:The answer provided below discusses a set of plausible events that is consistent with the allowance and write-off activity reported over the period 1994 to 1996. The managementÕs actual explanation for the changes in provision for doubtful accounts is also provided below.
1996 1995 1994Provision for doubtful accounts/revenue 0.95% 6.79% 4.32%Allowance for doubtful accounts/ Gross accounts receivable 28.40% 24.56% 16.61
%
1994 to 1995
Provision for doubtful accounts has increased probably due to higher than expected customer defaults. This is reflected in the higher ratio of allowance for doubtful accounts to gross accounts receivable at the end of 1995 when compared to 1994.
1995 to 1996
Provision for doubtful accounts for 1996 is at a historically low figure as a percentage of revenues. However, the allowance for doubtful accounts as a percentage of gross accounts receivable has increased further to 28.4% in 1996 from 24.56% in 1995. Note that the provision for doubtful accounts for 1996 equals the change in allowance for doubtful accounts over this period indicating that no accounts receivable were written off during the year. It appears that provision for doubtful accounts entirely represents anticipated or expected bad
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debts for revenues not yet collected. In addition, during 1996, it seems that the company may be continuing to pursue claims against its customers for whom it has already reported provision for doubtful accounts during 1995. In such cases, the company will not yet write off these accounts until a final resolution of the claims. This appears to have resulted in a higher percentage of allowance for doubtful accounts as a percentage of gross accounts receivable.In the management discussion and analysis section of the 10-K report, the management of Buck Hills Falls Company provided the following explanations for the changes in provision for doubtful accounts:
1994 to 1995
ÒGeneral and administrative expenses increased 11.2% in 1995 as compared to 1994, principally resulting from increases in legal and accounting fees, bad debt expense and depreciation expense…Bad debt expense increased…because of increased provision for uncollectible receivables.Ó (emphasis added)
1995 to 1996
ÒBad debt expense decreased…due to uncollectible accounts relating to the Buck Hill Inn and other accounts receivable being written off in 1995.Ó
Consistent with the conjecture, it appears that, during 1995, the company experienced higher bad debts in one of its operations (Buck Hill Inn). However, we have no direct evidence to corroborate our conjecture on the higher allowance for doubtful accounts as a percentage of gross accounts receivable.
∑P7-6. Cash discounts and returns
Note to instructor: This problem covers cash discount/credit terms not discussed in the chapter and, thereby, provides an opportunity to introduce these issues.
Requirement 1:1/1/98: To record sale of beer :
DR Accounts receivable $45,000 CRÊSales revenue $45,000
To record expected sales returns:DR Sales returns $2,250 CRÊAllowance for sales returns $2,250
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Note: Allowance for sales returns is a contra asset account for accounts receivable. Similar to the allowance for doubtful accounts, it is subtracted from Gross accounts receivable in the balance sheet. It is calculated at 5% of $45,000.
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1/9/98: To record receipt of payment:
DR Cash $21,825DR Cash discount 675 CRÊAccounts receivable $22,500
Note: The credit terms Ò3/10, n/30Ó means that the customer gets a 3% cash discount for payment made within 10 days. However, the entire amount is due within 30 days. Since the customers settled half of the receivables within 10 days, they are entitled to a 3% cash discount ($45,000 ´ 0.50 ´ 0.03 = $675).
1/15/98: To record return of beer from customers:
DR Allowance for sales returns $2,000 CRÊAccounts receivable $2,000
Note: This reflects the actual return of goods that was anticipated earlier.
1/28/98: To record receipt of payment:
DR Cash $20,500 CRÊAccounts receivable $20,500
Note: Balance due is $22,500 ($45,000 ´ 0.50) minus $2,000 of sales return. Since the payment was received after the 10th day, no cash discount is given to the customers.
DR Allowance for sales returns $250 CRÊSales returns $250
Note: Recall that expected sales returns of $2,250 were recorded on January 1, 1998. However, since the actual sales returns were only $2,000, we reverse the 1/1/98 journal entry to the extent of $250.
Requirement 2:Journal entries prior to January 15, 1998 are unaffected.
1/15/98: To record return of beer from customers:
DR Allowance for sales returns $2,250DR Sales returns 750 CRÊAccounts receivable $3,000
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Note: This reflects the actual return of goods to the extent it was anticipated earlier ($2,250). For goods returned in excess of expected sales returns ($3,000 - $2,250), we decrease the net revenue by debiting sales returns and decreasing accounts receivable further by $750.
1/28/98: To record receipt of payment:
DR Cash $19,500 CRÊAccounts receivable $19,500
Note: Balance due is $22,500 ($45,000 ´ 0.50) minus $3,000 of sales returns. Since the payment was received after the 10th day, no cash discount is given to the customers.
Requirement 3: 1/1/98: To record sale of beer:
DR Accounts receivable $45,000 CRÊSales revenue $45,000
1/9/98: To record receipt of payment:
DR Cash $21,825DR Cash discount 675 CRÊAccounts receivable $22,500
Note: The credit terms Ò3/10, n/30Ó mean that the customer gets a 3% cash discount for payment made within 10 days. However, the entire amount is due within 30 days. Since customers settled half of the receivables within 10 days, they are entitled to a 3% cash discount ($45,000 ´ 0.50 ´ 0.03 = $675).
1/15/98: To record return of beer from the customers:
DR Sales returns $2,000 CRÊAccounts receivable $2,000
Note: Since expected sales returns were not recorded, actual returns decrease net revenue by a debit to sales returns.
1/28/98: To record receipt of payment:
DR Cash $20,500 CRÊAccounts receivable $20,500
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Note: Balance due is $22,500 ($45,000 ´ 0.50) minus $2,000 of sales returns. Since the payment was received after the 10th day, no cash discount is given to the customers.Requirement 4:Assuming the company uses the calendar year as its fiscal year, all transactions pertaining to the sale of beer took place within one accounting period (sale of goods, return of goods, and collection of cash). However, if sales revenue is recorded in one accounting period and actual sales returns are recorded in the following period, then the matching principle is likely to be violated. This problem is mitigated by recording expected sales returns in the same period as when sales revenue is recorded. A second advantage is that the users of the financial statements might receive more information under the expected sales return approach since material deviations from expectations will affect future financial statements (See Requirement 3). If disclosed, this might provide evidence of the managerÕs ability to forecast sales returns. However, in some companies, estimated sales returns may not be materially different from actual sales returns, in which case, firms might minimize their bookkeeping costs by recording sales returns when goods are actually returned.
Requirement 5:If the customer decides to take advantage of the cash discount, the optimal time to do this is on the tenth day (i.e., the customer does not obtain any benefit by paying any sooner). If the customer decides not to take the cash discount, the full amount is due on the 30th day. (Once again, the customer does not obtain any benefit by paying any sooner.) Consequently, to take advantage of the cash discount, the customer pays 20 days sooner than it would otherwise.
Given that its incremental borrowing rate is 18%, the customer could borrow $21,825 and pay interest for 20 days (i.e., $21,825 ´ 18% ´ 20/365 = $215)Ñi.e., it has to pay $22,040 ($21,825 + $215) on the borrowing. However, if it had waited for the entire credit period of 30 days, then it would have to pay $22,500 to Hillock Brewing. Consequently, by taking advantage of the cash discount through borrowing, the customer is better off to the extent of $460 ($22,500 minus $22,040). The $460 also represents the difference between the cash discount ($675) and the interest cost on the borrowing ($215). In summary, the customer is better off taking advantage of the cash discount.
Another way to answer the question is to view the cash discount ($675) as the return on investment in accounts receivable ($21,825) for 20 days. This converts into an annualized rate of return of 56.4% ($675/$21,825 ´ 365/20 ´ 100) when compared to the incremental borrowing rate of 18%.
P7-7. Factoring receivables
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Note to the instructor: When receivables are transferred with recourse, the cash received from the factor is treated as an operating or a financing cash inflow depending on whether the transfer of receivables receive the sale or loan treatment under the GAAP. To highlight this aspect, the solution also indicates the effects of each cash transaction on the statement of cash flows for all parts of the problem.
Requirement 1:
a) To record the sale of receivables to the factor:
Calculation of the proceeds from the factorGross accounts receivable factored $200,000(-) Interest for one month (200,000 ´ 0.12 ´ 1/12) (2,000)(-) Factoring fee (6% of $200,000) (12,000)(-) Holdback for returns (5% of $200,000) (10,000)Net proceeds $176,000
DR Allowance for uncollectibles $4,000DR Cash 176,000DR Loss on sale of receivables 10,000DR Receivable from factorÑholdback of 5% 10,000
CR ÊAccounts receivable $200,000
Since the factor is responsible for all the bad debts on the factored receivables, the allowance for uncollectibles with respect to these receivables should be eliminated (by debiting the allowance account). The loss on sale of receivables can be broken down into three components as follows:
Interest expense $2,000 Factoring fee 12,000 (-) Elimination of allowance (4,000)Loss on sale of receivables $10,000
∑ In essence, the loss on sale of receivables represents several different income statement items. While there is loss of information from combining these items into a single loss account, the above journal entry is one of the most common approaches to record sale of receivables.
∑ Note that the entire Interest expense has been recorded at the time of sale as part of the loss amount. However, for long-term receivables, the financing cost (Interest expense) will be recorded (and probably paid) over the duration of the receivablesÕ life.
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Effect on statement of cash flows: The $176,000 received from the factor will also show up as part of operating cash flows. Since the risk of credit loss (bad debts) is borne by the factor, the cash received is treated as part of operating cash flows (i.e., it is equivalent to collecting cash from the customers). The fact that the customers have not yet paid is irrelevant.
An alternative approach is to separately show the three components included in the loss on sale of receivables as follows:
DR Allowance for uncollectibles $4,000DR Cash 176,000DR Interest expense 2,000DR Factoring fee 12,000DR Receivable from factorÑholdback of 5% 10,000
∑ The debit to the allowance for uncollectibles and the credit to the bad debt expense represent the reversal of the journal entry for bad debt expense on the $200,000 of the factored receivables. The intuition behind this is that the factoring fee is expected to include a compensation for the credit risk (bad debts) borne by the factor. Consequently, by not reversing the bad debt expense, we will be double counting.
∑ The loss on sale of receivables in the original journal entry is now decomposed into two debits (to interest expense and factoring fee) and a credit (bad debt expense reversal). However, the net effect on the income statement ($2,000 + $12,000 - $4,000 = $10,000) is identical.
b) To record return of $3,000 of merchandise:DR Sales returns $3,000
CR ÊReceivable from factor $3,000
c) To record receipt of payment from the factor:DR Cash $7,000
CR ÊReceivable from factor $7,000
Effect on statement of cash flows: The $7,000 cash is an operating cash flow.
d) The actual bad debts incurred by the factor were $7,500.
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Atherton will not record a journal entry to record this event. Recall that the receivables were sold without recourse for bad debts, in which case, the factor is responsible for all the bad debts. In the given scenario, the actual bad debts of $7,500 were more than the expected bad debts of $4,000 (2% of 200,000). Consequently, the factor might have suffered an unexpected loss. On the other hand, if the actual bad debts had been only $1,000, the factor would have reaped some benefits. In any case, Atherton is paying a fixed sum (the factoring fee) so the factor is bearing the risk of credit loss.
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General Comments:
Before answering parts 2 and 3, it is instructive to compare the information provided in part 1 with that of parts 2 and 3. First, note that the factoring fee charged is substantially lower for parts 2 and 3 (2.5%) compared to the Òwithout recourseÓ scenario (6%). The extra 3.5% paid to the factor is to cover the expected bad debts and the additional administrative costs of pursuing the delinquent accounts. Second, the hold back for parts 2 and 3 (7%) is higher than the 5% holdback in the Òwithout recourseÓ scenario. In part 1, the factor was not responsible for sales returns and, consequently, held back 5%, being the expected sales returns from the receivables. In parts 2 and 3, the factor is also not responsible for bad debts, and therefore, is holding back an additional 2%. Third, unlike part (a), the receivables are transferred in parts 2 and 3 without notification. Given Atherton is responsible for all bad debts,it has stronger incentives to follow up on the delinquent customers. Hence, transferring without notification may be a more efficient approach to collecting the receivables.
It is important to remember that a company might be able to treat a transfer of receivables with recourse as a ÒsaleÓ as long as it satisfies the three conditions listed in SFAS No. 125. The purpose of parts 2 and 3 is to demonstrate the differential financial statement effects depending on whether the transfer of receivables is treated as a sale or a borrowing under GAAP. In addition, many of the financial reporting and analysis issues that are discussed here are also very relevant in securitization transactions.
Requirement 2:a) To record the sale of receivables to the factor:
Calculation of the proceeds from the factorGross accounts receivable factored $200,000(-) Interest for one month (200,000 ´ 0.12 ´ 1/12) (2,000)(-) Factoring fee (2.5% of $200,000) (5,000)(-) Holdback (7% of $200,000) (14,000)Net proceeds $179,000
DR Loss on sale of receivables $ 7,000
DR Cash 179,000CRÊAccounts receivable $186,000
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Note, in effect, the factor is ÒfinancingÓ $186,000 worth of receivables (i.e., net proceeds + interest cost + factoring fee), i.e., the factor is providing $179,000 cash today with the expectation of receiving $186,000 later.
Effect on statement of cash flows: Since the receivables are eliminated from the books, the $179,000 received from the factor will show up as part of the operating cash flows.
Since Atherton continues to be responsible for all the bad debts on the factored receivables, the allowance for uncollectibles with respect to these receivables should not be eliminated. The loss on sale of receivables can be broken down into two components as follows:
Interest expense $2,000 Factoring fee 5,000 Loss on sale of receivables $7,000
b) To record return of $3,000 of merchandise:DR Sales returns $3,000
CRÊAccounts receivable $3,000
c) To record bad debts written off on the transferred receivables. Recall that Atherton had anticipated only $4,000 of bad debts, and, consequently, the excess write-offs increase bad debt expense.
DR Bad debt expense $1,500DR Allowance for doubtful accounts 4,000
CRÊAccounts receivable $5,500
d) To record the collection from the customers and pay off to the factor. Since the transfer was treated as a sale, only the net proceeds (i.e., the difference between the collections and the payoff) is recorded in the books.
Face value of receivables $200,000 (-) Sales returns (3,000)(-) Bad debts written off (5,500)Cash collected from customers $191,500 (-) Due to the factor (186,000)= Net proceeds $5,500
DR Cash $5,500CRÊAccounts receivable $5,500
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Effect on statement of cash flows: The $5,500 cash is an operating cash flow.
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Requirement 3:a. To record the transfer of receivables to the factor:
Calculation of the proceeds from the factorGross accounts receivable factored $200,000 (-) Interest for one month ($200,000 ´ 0.12 ´ 1/12) (2,000)(-) Factoring fee (2.5% of $200,000) (5,000)(-) Holdback (7% of $200,000) (14,000)Net proceeds $179,000
DR Cash $179,000DR Interest expense 2,000DR Factoring fee 5,000
CRÊLoans payable $186,000
Effect on statement of cash flows: The $186,000 borrowing will show up as part of financing inflow, whereas the $7,000 will show up as operating outflow. Alternatively, the company might show the net cash inflow of $179,000 as a financing flow.
b) To record return of $3,000 of merchandise:DR Sales returns $3,000
CRÊAccounts receivable $3,000
c) To record bad debts written off on the transferred receivables. Recall that Atherton had anticipated only $4,000 of bad debts, and consequently, the excess write-offs increase bad debt expense.
DR Bad debt expense $1,500DR Allowance for doubtful accounts 4,000
CRÊAccounts receivable $5,500
d) To record receipt of payments from customers:
Face value of receivables $200,000 (-) Sales returns (3,000)(-) Bad debts written-off (5,500)Cash collected from customers $191,500
DR Cash $191,500CRÊAccounts receivable $191,500
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Effect on statement of cash flows: $191,500 is an operating inflow.
e) To record the payment to the factor:DR Loans payable $186,000
CRÊCash $186,000
Effect on statement of cash flows: $186,000 is a financing outflow.
P7-8. Reconstructing T-accounts
Requirement 1:
Journal Entries
DR CRAllowance for doubtful accountsBeginning balance $4,955,000 Provision for doubtful accounts (incomestatement) 5,846,000
Bad debts written-off (plug number) $6,876,000 Ending balance $3,925,000
DR Gross accounts receivable $137,002,00CRÊRevenue $137,002,000
DR Provision for doubtful accounts $5,846,000 CRÊAllowance for doubtful accounts $5,846,000
DR Allowance for doubtful accounts $6,876,000 CRÊGross accounts receivable $6,876,000
DR Cash $134,833,00CRÊGross accounts receivable $134,833,000
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Requirement 2:1994 1993 1992
Provision for doubtful accounts as % of revenue 4.27% 5.98% 6.30%
Revised provision for 1994 using the 1993 percentage ($137,002,000 ´ 5.98%) $8,192,720
DR CRAllowance for doubtful accountsBeginning balance $4,955,000 Provision for doubtful accounts (from above) 8,192,720 Bad debts written-off $6,876,000 Ending balance (plug number) $6,271,720
Balance sheet presentation of receivables (1994)Gross accounts receivable $26,944,000Less: Allowance for doubtful accounts 6,271,720 Net accounts receivable $20,672,280
Note: Altering the 1994 provision for doubtful accounts does not change gross accounts receivable.
The revised operating income is calculated below:
1994Operating income before taxes (as reported) $6,900,000 (+) Provision for doubtful accounts (as reported) 5,846,000 (-) Provision for doubtful accounts (revised) 8,192,720Operating income before taxes (revised) $4,553,280 Decrease in operating income -34.01%
Note that the operating income would have decreased by 34% if Ramsay had reported the 1994 bad debts at the same percentage of revenue as it did in 1993. Although Ramsay probably has good reasons for the lower provision for doubtful accounts, it is important for an analyst to follow up with RamsayÕs management for information regarding this decline.
Requirement 3:1994 1993
Allowance for doubtful accounts as a % of gross A/R 14.57% 15.66%
Revised balance in allowance account($26,944,000 ´ 15.66%) $4,218,114
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DR CRAllowance for doubtful accountsBeginning balance $4,955,000 Provision for doubtful accounts (plug number) 6,139,114Bad debts written off $6,876,000 Ending balance (from above) $4,218,114
The revised operating income is calculated below:
1994 Operating income before taxes (as reported) $6,900,000(+) Provision for doubtful accounts (as reported) 5,846,000(-) Provision for doubtful accounts (revised) (6,139,114)Operating income before taxes (revised) $6,606,886Decrease in operating income -4.25%
Operating income would have decreased only by about 4% if Ramsay had reported the 1994 allowance for doubtful accounts at the same percentage of gross receivables as it did in 1993.
Requirement 4:Requirements 2 and 3 lead to substantially different estimates for bad debt expense (provision for doubtful accounts). Recall that a bad debt expense calculation based on the sales revenue approach would have decreased RamsayÕs operating income by 34%. However, the decline would have been much smaller under the gross receivables approach. To better understand this difference, let us first calculate the gross accounts receivable as a percentage of revenue:
1994 1993 Gross accounts receivable $26,944,000 $31,651,000 Revenue 137,002,000 136,354,000 Year-end gross A/R as a % of revenue 19.67% 23.21%
It appears that Ramsay has apparently improved its accounts receivable collections. At the end of 1994, the receivables are less than 20% of revenue compared to a figure of more than 23% at the end of 1993. If Ramsay had maintained the same percentage of receivables (23.21%) at the end of 1994 also, then what would have been the balance in gross accounts receivable?
The above table suggests that Ramsay would have reported almost $5 million of additional receivables at the end of 1994 if the receivables balance continued to be 23.21% of revenue. This suggests that the substantial difference in the answers to Requirements 2 and 3 appears to be due to substantial improvement in the quality of RamsayÕs accounts receivable, i.e., improved collections and lower write-offs.
The intertemporal pattern of the bad debt expense is also consistent with this intuition:
1994 1993 1992Provision for doubtful accounts as % of Revenue 4.27% 5.98% 6.30%
The bad debt expense as a percentage of revenue has monotonically decreased from 6.3% to about 4.3% over a three-year period.
However, an analyst should obtain corroborating information from the management to further substantiate this inference. This is because the observed trend in the provision for doubtful accounts is also consistent with under-provision for expenses. For instance, although the receivables balance is lower at the end of 1994, they might consist primarily of lower quality (or substantially aged) receivables.
P7-9. Restructured note receivable
Requirement 1:
Warren CompaniesTo record the fully depreciated asset at its fair market value:
DR Equipment $14,000CRÊGain on disposal of asset $14,000
To record the settlement:DR Note payable $48,000DR Interest payable 2,400
CRÊCash $20,000CRÊEquipment 14,000CRÊExtraordinary gain on debt 16,400
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General Equipment ManufacturersTo record the settlement:
DR Cash $20,000DR Equipment 14,000DR Loss on receivable restructuring 16,400 CRÊNote receivable $48,000
CRÊInterest receivable 2,400
Requirement 2:Warren Companies1/1/97: To record the modified sum:
DR Note payable $48,000DR Interest payable 2,400
CRÊRestructured note payable $50,400
Calculation of Discount Rate:
Present value = future value ´ present value factor (3 years, ?? interest rate)i.e., $50,400 = $57,600 ´ present value factor (3 years, ?? interest rate)
Dividing both sides by $57,600, we have
Present value factor (3 years, ?? interest rate) = $50,400/$57,600 = 0.8750
i.e., 1/(1 + r)3 = 0.8750
Æ (1 + r)3 = 1/0.8750 = 1.1429
Æ (1 + r) = (1.1429)1/3 = 1.0455
Æ r = 1.0455 - 1 = 0.0455 or 4.55%
Alternately, this can also be obtained by interpolation.
Present value of Restructured Present value offuture flows @ 4% note amount future flows @ 5%
12/31/99: To record payment of amount due:DR Restructured note payable $57,600
CRÊCash $57,600
General Equipment Manufacturers1/1/97: To record the modified sum:
DR Restructured note receivable $49,757DR Loss on receivable restructuring 643 CRÊNote receivable $48,000 CRÊInterest receivable 2,400
Note: The restructured note is valued at $49,757, being the present value of $57,600 to be received in three years discounted at 5%. The factor is .86384.
12/31/97: To record interest receivable:DR Restructured note receivable $2,488 CRÊInterest income $2,488
($49,757 ´ 5% = $2,488)
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12/31/98: To record interest receivable:DR Restructured note receivable $2,612 CRÊInterest income $2,612
[($49,757 + $2,488) ´ 5% = $2,612]
12/31/99: To record interest receivable:DR Restructured note receivable $2,743
12/31/99: To record payment of amount due:DR Restructured note payable $48,000
CRÊCash $48,000
General Equipment Manufacturers1/1/97: To record the modified sum:
DR Restructured note receivable $41,464DR Loss on receivable restructuring 8,936 CRÊNote receivable $48,000 CRÊInterest receivable 2,400
Note: The restructured note is valued at $41,464, being the present value of $48,000 to be received in three years discounted at 5%. The factor is .86384.
12/31/97: To record interest receivable:DR Restructured note receivable $2,073 CRÊInterest income $2,073
($41,464 ´ 5% = $2,073)
12/31/98: To record interest receivable:DR Restructured note receivable $2,177
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CRÊInterest income $2,177[($41,464 + $2,073) ´ 5% = $2,177]12/31/99: To record interest receivable:
DR Restructured note receivable $2,286 CRÊInterest income $2,286
[($41,464 + $2,073 + $2,177) ´ 5% = $2,286]
12/31/99: To record receipt of amount due:DR Cash $48,000
CRÊRestructured note receivable $48,000
P7-10. Accounting for transfer of receivables
It seems that Ricoh Company is treating the discounting of receivables as a sale. Note that Ricoh indicates that Òtrade notes receivable discounted are contingent liabilities.Ó If Ricoh had treated the discounting of receivables as a borrowing, then there is no need for reporting the contingent liability since the borrowing would have been included in the balance sheet as a liability.
Crown Crafts appear to use a similar accounting treatment, i.e., the money received from the factor is considered as a liquidation of the receivables.
The following passage from FoxmeyerÕs footnote indicates that it is also using the sale treatment for the transfer of receivables: ÒSuch accounts receivable sold are not included in the accompanying consolidated balance sheet at March 31, 1994.Ó
There are substantial differences in the economics of the transactions. Crown Craft transfers the receivable without recourse as to credit losses, i.e., in effect, the factor becomes the ÒtrueÓ owner of the receivables by bearing the credit risk. Whereas, Ricoh is still responsible for all the credit risk since the transfers are with full recourse, i.e., Ricoh retains the economic risk (i.e., risk of credit losses) of owning the receivables. However, Foxmeyer falls somewhere in between since the investors in the companyÕs receivables have only limited recourse against the company. Consequently, it is imperative for an analyst to carefully examine the details of the factoring or securitization transactions to find out who is really bearing the risks of receivables ownership. If the ownership risks (and the corresponding rewards) are retained by the company, then the transaction is more like a borrowing where the lender does not directly bear the risk of owning the security (i.e., the receivable). On the other hand, if the ownership risks are borne by the factor, then the company has, in effect, sold the receivables, and, therefore, their removal from the balance sheet is consistent with economic reality. In essence, companies facing different economic realities
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might chose similar accounting treatment because they ÒsatisfyÓ the requirements under the GAAP.
DR Bad debt exp. $5.2 NO ENTRYCR Allowance for doubtful accounts $5.2
1989 DR Allowance for doubtful accounts $3.9 DR Bad debt exp. $3.9CR Accounts receivable $3.9 CR Accounts receivable $3.9
DR Bad debt exp. $7.0 NO ENTRYCR Allowance for doubtful accounts $7.0
1990 DR Allowance for doubtful accounts $7.2 DR Bad debt exp. $7.2CR Accounts receivable $7.2 CR Accounts receivable $7.2
DR Bad debt exp. $17.1 NO ENTRYCR Allowance for doubtful accounts $17.1
1991 DR Allowance for doubtful accounts $11.3 DR Bad debt exp. $11.3CR Accounts receivable $11.3 CR Accounts receivable $11.3
DR Bad debt exp. $9.5 NO ENTRYCR Allowance for doubtful accounts $9.5
1992 DR Allowance for doubtful accounts $8.4 DR Bad debt exp. $8.4CR Accounts receivable $8.4 CR Accounts receivable $8.4
DR Bad debt exp. $15.3 NO ENTRYCR Allowance for doubtful accounts $15.3
Requirement 4:The allowance method is consistent with the matching principle underlying the accrual accounting model, whereas the direct write-off method is not.
Requirement 5:The cumulative income difference is equal to the change in the balance of the allowance account from 1988 to 1992.
Allow. for doubtful accounts end. 1992: $26.4Allow. for doubtful accounts beg. 1988: 8.0
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Income difference (cumulative) $18.4
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The proof is to check the sum of the yearly income differences:
Income Difference
Year
1988 ($.3)
1989 (3.1)
1990 (9.9)
1991 1.8
1992 (6 .9 )
Total ($18 .4 )
Calculate the same numbers by subtracting the ÒexpenseÓ that would be reported under the allowance method from what would be reported under the direct write-off method.
Income Difference
Year
1988 ($4.9 - $5.2)
1989 (3.9 - 7.0)
1990 (7.2 - 17.1)
1991 (11.3 - 9.5)
1992 (8.4 - 15.3 )
Total ($18.4)Requirement 6:If the firm wanted to be conservative, the initial provision could be increased by the entire $10.0 million. If the firm wanted to be optimistic, the initial provision would not be increased at all. Perhaps, the best recommendation to make is to take a middle ground and accrue a portion of the $10.0. For example, management could be asked to make an estimate of the probability that the customer will go bankrupt (e.g., 35.0%), and then the initial provision could be increased by this probability times the $10.0 (i.e., $3.5 million). ManagementÕs estimate of the probability might be based on how often customers with similar financial problems in the past eventually went bankrupt and did not pay their account balance.
Requirement 7:
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a) Here, management might want to take the entire $10.0 million as an additional provision because earnings before income taxes of $65.0 million is well below the bonus plan minimum of $100.0 million. In other words, by taking the entire $10.0 million as an additional bad debt provision, management doesnÕt lose any bonus money. In fact, by taking the additional provision this year, managers may enhance their bonus in the future (e.g., next year) by not having to take an extra provision in a year when they are Òin the bonus range.Ó
b) Here, management might not want to take any additional bad debt provision because earnings before income taxes of $110.0 million is above the bonus plan minimum of $100.0 million. Every dollar of extra bad debt provision taken reduces the bonus by 1%. For example, taking an additional provision of $5.0 million costs management $50,000 in bonus money.
c) Here, management might want to take the entire $10 million as an additional bad debt provision because earnings before income taxes of $225.0 million exceeds the ceiling of the bonus plan ($200.0 million). Here, management doesnÕt lose any bonus money by taking any or all of the $10 million as an additional bad debt provision. In fact (as in part a), by taking the additional provision this year, managers may enhance their bonus in the future (e.g., next year) by not having to take an extra provision in a year when they are Òin the bonus range.Ó
d) Here, management might want to take an additional provision of $5.0 million because earnings before income taxes of $205.0 million exceeds the ceiling of the bonus plan ($200.0 million) by $5.0 million. Here, as long as the extra provision doesnÕt exceed $5.0 million, management doesnÕt lose any bonus money. Any amount above $5.0 million, of course, begins to reduce the bonus.
The moral of the story is that managementÕs financial reporting decisions are not going to be made in isolation of other factors.
Requirement 8:a) Managers might use the provision for bad debts to help avoid violation of debt covenant restrictions that are written in terms of accounting numbers. Some debt contracts contain minimum (or maximum) levels that various financial ratios must adhere to or the firm will be declared in technical default on the debt. These ratios are often a function of reported earnings and, thus, can be improved by postponing the recognition of expenses into future years or by accelerating the recognition of revenue. Ratios/accounting numbers often seen in debt contracts include interest coverage, net worth, current ratio, debt to equity, debt to total assets, among others.
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Requirement 9:ÒManagingÓ a financial statement item suggests the ability to influence net income and the pattern of net income growth from year to year. Smoothing income and taking Òbig-bathÓ charge-offs are examples.
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Other items that can potentially be managed include:
a) Depreciation method choice.
b) Useful lives for tangible and intangible assets.
c) Estimates of future warranty expense by firms that offer product warranties (e.g., car makers like GM and Ford).
d) The timing and amounts for special charges/write-downs, restructurings, asset sales, etc.
e) Inventory method choice.
f) Write-offs or write-downs of obsolete inventory.
g) Related to (b), changes in the useful lives or salvage values of depreciable assets.
C7-2. Great Southwest Corporation (KR): Valuing notes and recording interest(Adapted from In the Matter of Reports of Great Southwest Corporation, Securities Exchange Act of 1934, Section 15(c)(4), Release No. 9934, January 15, 1973)
Requirement 1:The journal entries are not consistent with GAAP because they do not reflect the present value of consideration given for the amusement park. Despite the various numbers and terms (e.g., stated interest and principal payments) used in the problem with respect to the note, what GSC has actually received as consideration is $5,412,500 (down payment + prepaid interest) cash up front and the promise of a future cash flow stream of $2,137,500 per year over 35 years, starting three years from signing of the contract. Assuming (for the monent) that the interest rate stated in the contract is appropriate, the future cash flows should be discounted at an interest rate of 6.5%.
The 35 payments of $2,137,500 beginning on 1/1/72 and ending on 1/1/06 can be viewed as a 35-year ordinary annuity from 1/1/71. The lump sum present value of all those payments discounted at 6.5% on 1/1/71 is ($2,137,500 ´ 13.68695673 = $29,255,868). This lump sum amount on 1/1/71 can then be discounted back 2 years at 6.5% to get the value of the note on 1/1/69 which is ($29,255,868 ´ .881659283 = $25,793,709).
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Some students may feel more comfortable seeing the solution in amortization table form. The following table provides details of the present value calculation as well as the amortization of the notes receivable:
$49,018,791 $74,812,500 $(25,793,709) $25,793,709 = Total PV
1 Interest revenue of $1,676,591 is calculated by multiplying the 1969 beginning of year balance in notes receivable ($25,793,709) by 6.5%.
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The consideration received is calculated as follows:
Down payment $2,000,000 Prepaid interest 3,412,500 Present value of note receivable 25,793,709 Total consideration $31,206,209
1/1/69: To record sale of amusement park for cash and a note:
Even though $3,412,500 is called prepaid interest, the relevant factor for measuring the gain is the present value of current and future cash flows. Consequently, the breakdown between down payment and stated interest is not necessary when recording the sale of the amusement park.
DR Cash $5,412,500DR Note receivable 25,793,709 CRÊAmusement park $22,000,000
CRÊGain on sale 9,206,209
Requirement 2:This requirement illustrates the effects of a difference between the stated rate and the prevailing market interest rate. Contracts might specify different stated rates to manage the contracting partiesÕ cash flow streams. For example, zero-coupon bonds have no periodic interest payments even though the effective interest rate is positive. However, for valuation purposes, what matters is the present value of current and future cash flows discounted at a rate commensurate with the riskiness of the future cash flows (referred to as the effective interest rate).
The 35 payments of $2,137,500 viewed as an ordinary annuity from 1/1/71 are:
$2,137,500 ´ 9.644158973 = $20,614,389
Discounted back to 1/1/69:
$20,614,389 ´ .82644628 = $17,036,686
Thus, the present value of the note at January 1, 1969 at 10% would be $17,036,686.
The following table provides details of the present value calculation as well as the amortization of the note receivable using a discount rate of 10%:
$57,775,814 $74,812,500 $(17,036,66 ) $17,036,686 = Total PV
The consideration received is now recalculated as follows:
Down payment $ 2,000,000 Prepaid interest 3,412,500 Present value of note receivable 17,036,686Total consideration $22,449,186
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1/1/69: To record sale of amusement park for cash and a note:DR Cash $ 5,412,500DR Note receivable 17,036,686
CRÊAmusement park $22,000,000CRÊGain on sale 449,186
12/31/69: To record 10% interest on 1/1/69 book value of $17,036,686:DR Note receivable $1,703,669
CRÊInterest revenue $1,703,669
12/31/70: To record 10% interest on 1/1/70 book value of $18,740,354:DR Note receivable $1,874,035 CRÊInterest revenue $1,874,035
12/31/71: To record 10% interest on 1/1/71 book value of $20,614,390:DR Note receivable $2,061,439 CRÊInterest revenue $2,061,439
1/1/72: To record receipt of cash payment:DR Cash $2,137,500 CRÊNote receivable $2,137,500
12/31/72: To record 10% interest on 1/1/72 book value of $20,538,329:DR Note receivable $2,053,833 CRÊInterest revenue $2,053,833
C7-3. Spiegel Inc. (KR): Analyzing receivables growth
Dear Ms. Kang:
I have had a chance to review the information on SpiegelÕs accounts receivable. Before I discuss the results of my analysis, let me first compute more precisely some of the ratios you had mentioned in your letter:
1995 1994 % Change in net sales 6.63% 15.81%% Change in net receivables -34.04% 12.74%% Change in receivables owned -31.77% 12.09%
I am not sure whether you used gross or net receivables in your calculations. However, the inferences are very similar either way. Consequently, unless it impacts my analysis, I will use gross and net receivables interchangeably.
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I have also been able to verify your receivables turnover calculations:
1995 1994 1993Net sales $2,886,225 $2,706,791 $2,337,235 Receivables, net (from bal. sheet) 742,480 1,125,728 998,525 Average receivables 934,104 1,062,127
Receivables turnover ratio 3.09 2.55 Collection period (days) 118 143
The collection period has indeed decreased from 143 days to less than 120 days. However, the decline appears to be primarily due to increased usage of factored receivables rather than faster payments by customers. One approach to examining the effect of factoring is to estimate the receivables turnover assuming that Spiegel does not factor any of the receivables. This would give us a better estimate of how fast SpiegelÕs customers are paying off their debt.
To perform this analysis, we first have to figure out what the receivables balance would have been without any factoring. These numbers are provided under receivables generated from operations, which Spiegel calls receivables serviced. Note that receivables owned represents those receivables that are included in SpiegelÕs balance sheet under net receivables. Over the last 3 years, the proportion of the factored receivables (receivables sold) has continuously increased:
1995 1994 1993Receivables sold $1,180,000 $ 480,000 $ 330,000 Receivables owned 821,081 1,203,444 1,073,618 Total receivables generated from operations $2,001,081 $1,683,444 $1,403,618
1995 1994 1993Receivables sold 58.97% 28.51% 23.51%Receivables owned 41.03% 71.49% 76.49%Total receivables generated from operations 100.00% 100.00% 100.00%
Note that the factored receivables as a percentage of total receivables has more than doubled from 1994 to 1995. To better understand the effect of this on receivables turnover, let us recalculate SpiegelÕs receivables turnover using the total receivables rather than just the receivables owned:
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1995 1994 1993Net sales $2,886,225 $2,706,791 $2,337,235 Receivables generated from operations 2,001,081 1,683,444 1,403,618 Average receivables 1,842,263 1,543,531 Receivables turnover ratio 1.57 1.75Collection period (days) 233 208
These calculations suggest that the customers are, in fact, taking a longer time to pay off their debt (233 days in 1995 versus 208 days in 1994). However, SpiegelÕs receivables turnover ÒimprovedÓ because a substantial portion of its receivables are off the balance sheet due to increased factoring.
One consideration we have to keep in mind is that Spiegel has sold its receivables without recourse for bad debt risk. Consequently, whether the cash is received from the factor or directly from the customer may not be of much concern to an analyst. However, the long-run implications of the factoring are not clear. Can Spiegel continue to factor almost 60% of receivables in the near future? Since the ÒtrueÓ collection period has indeed deteriorated, it might have implications for future factoring agreements. For instance, the factors might demand a larger factoring fee due to the extended collection time. Alternatively, the factors might accept only transfers of receivables with recourse to avoid bearing any increased bad debt risk from slower collection.
The second issue relates to the accounting for sale of receivables. To get better intuition on this, let us first try to understand the journal entry recorded by Spiegel when it factors its receivables. Recall that Spiegel is still responsible for sales returns although the investors in the securitized receivables bear the bad debt risk. Consequently, while an allowance for returns on the factored receivables must continue to be maintained in SpiegelÕs books, the allowance for uncollectibles on those receivables is eliminated. Let me draw your attention to the following information that you provided to me earlier:
Allowance for doubtful accounts1995 1994 1993
Beginning balance $49,954 $46,855 $37,231 Increase due to CR to allowance acct. 91,612 79,183 69,160 Reduction for receivables sold (33,600) (6,300) (1,609)Other 695 Accounts written off (67,134) (69,784) (58,622)Ending balance $40,832 $49,954 $46,855
ÒOtherÓ represents the beginning balance of Newport News which was acquired in 1993.
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1995 1994 1993Receivables sold (end of year balance) $1,180,000 $480,000 $330,000
1995 1994 1993Receivables sold during the year $700,000 $150,000 $330,000Reduction in allow. for receivables sold 33,600 6,300 1,609
Now letÕs try to reconstruct the journal entry for the sale of receivables during 1995:
DR Cash (plug number) $685,037DR Allowance for doubtful accounts (+A) 33,600 CR Receivables $700,000 CR Gain on sale of receivables (from footnote) 18,637
Note that the gain on sale of receivables is included under other revenue.
Since $700,000 of receivables have been removed from the books, Spiegel cannot continue to show the corresponding allowance for returns as a contra asset account (Note: It appears that the investors in the factored receivables are not holding back any funds for expected sales returns). Instead, Spiegel seems to reclassify the allowance for returns on the factored receivables as a liability. This explains why a portion of the allowance for sales returns is disclosed under accrued liabilities. Recall that Spiegel continues to be responsible for sales returns, so the allowance for returns cannot be eliminated altogether.
If Spiegel is selling receivables with a present value of expected net cash flows of only $666,400 ($700,000 minus $33,600), why are the investors paying $685,037 for these receivables? Why the $18,637 disparity exists is not readily apparent. One possibility is that the interest rate on the customer receivables is higher than the rate of return earned by the investors on the receivables. If so, the gain on sale represents a Òbrokerage feeÓ retained by Spiegel for obtaining financing for its customers; i.e., it is too costly for the customers to obtain outside financing and too costly for the investors in receivables to independently evaluate the quality of receivables. Consequently, Spiegel earns a Òbrokerage feeÓ for acting as an intermediary. A second possibility is that market interest rates have decreased from the time the receivables were first created to the time the receivables were sold to the investors. If this is true, the higher cash received represents the lower prevailing discount rate at the time of the sale of receivables. In any case, it is important to understand the reasons for the gain on sale of receivables to evaluate the quality of SpiegelÕs earnings.
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C7-4. Thompson Traders (KR): Bad-debt analysis
Tony BarclayÕs calculation:
The following table provides the necessary calculations to support Tony BarclayÕs analysis.
However, TonyÕs analysis suffers from an important limitation. By expressing bad debts written off as a percentage of revenues, Tony is comparing apples and oranges. Note that the bad debts written off in a given year pertains to sales made during that year as well as the previous year. This could lead to biased estimates for bad debt expense since the matching principle requires matching the revenue of a given year with all the bad debts relating to that yearÕs sale whether written off in the same period or not. This takes us to Ian SpencerÕs analysis.
Ian SpencerÕs calculation:
The following table provides the necessary calculations to support Ian SpencerÕs analysis:
As correctly pointed out by Ian, bad debts as a percentage of a given yearÕs sales has remained constant. (Note that the 1997 figure (2.44%) is incomplete since some of the 1997 receivables might be written off only in 1998.) Ian was
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able do this analysis by keeping track of all the bad debts pertaining to a given yearÕs sale. However, IanÕs conclusion to retain the current formula is misguided since the actual bad debts are 0.25% higher than the bad debt expense recorded under the current formula (i.e., 2.75% bad debt expense versus 3.00% ÒtrueÓ bad debts). Consequently, since the trend in bad debts is expected to remain at historical levels, the company should revise the formula to 3% of revenue.
Brian Joshi:
As pointed out by Brian Joshi, we have to not only revise the bad debt expense formula beginning 1997, but also adjust the balance in the allowance account to correct for the underestimation. However, the adjustment for the under-estimation must be treated as a change in an accounting estimate rather than a change in accounting principle. Moreover, there is no need to adjust the past financial statements to rectify the estimation error. On the contrary, the understatement in the allowance for doubtful accounts as of the end of 1996 must be corrected by increasing the bad debt expense for the year 1997.
The following table summarizes the actual transactions in the allowance for uncollectibles account:
Allowance Account (Actual = 2.75% of 1993 1994 1995 1996
To calculate the underestimation error, the following table estimates the balance in the allowance account assuming the company had reported bad debts at 3% of revenue for all prior years:
The bad debt expense for 1997 is calculated as follows:
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Bad debts based on 3% of $90,000 $2,700Correction of past estimation error 525Bad debt expense for 1997 $3,225
In essence, the company can use its accumulated historical experience to examine the accuracy of its bad debt estimation method. The historical data suggests that the company had consistently underestimated its bad debt provision. Consequently, the bad debt expense for 1997 includes a component to reflect the current yearÕs estimated bad debts using the revised formula plus a component reflecting the past underprovision.
The following table summarizes the actual transactions in the allowance for uncollectibles account through 1997:
Allowance for 1993 1994 1995 1996 1997 uncollectiblesBeginning balance - $ 225 $ 325 $ 475 $ 275(+) Bad debt expense $825 1,100 1,650 2,200 3,225(-) Bad debts written off (600) (1,000) (1,500) (2,400) (3,000)Ending balance $225 $ 325 $ 475 $ 275 $ 500
Journal Entry:
DRr Bad debt expense $3,225 CRÊAllowance for uncollectibles $3,225
Note that the change in the bad debt formula will impact the bad debt expense of the future years also. Therefore, under GAAP, the company should disclose the impact of the change in this accounting estimate on its income statement for 1997 (i.e., $90,000 ´ 0.25% = $225). Notice that 0.25% is simply 3% minus 2.75%.
C7-5. The Software Toolworks, Inc. (KR): Account reconciliation and analysisRequirement 1:
DR CRAllowance for returnsBeginning balance $6,363,000 Provision for returns 10,942,000 Actual returns (plug number) $12,041,000 Ending balance $5,264,000
Allowance for doubtful accountsBeginning balance $4,151,000 Provision for doubtful accounts 946,000 Bad debts written off (plug number) $1,527,000 Ending balance $3,570,000
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DR CRAccounts receivable (gross)Beginning balance $ 34,754,000 Revenues (see below) 130,540,000 Actual returns (from allowance for returns a/c) $12,041,000 Bad debts written-off (from allowance for da) 1,527,000 Cash collected (plug number) 12,831,000 Ending balance $ 38,895,000
Revenues are calculated after adding back the provision for returns to the revenues reported in the financial statements.
1993 1992Revenues (net of provision for returns) $119,598,000 $102,646,000 Provision for returns 10,942,000 8,863,000Gross revenues $130,540,000 $111,509,000
While provision for returns is contra to the revenue account, provision for doubtful accounts is an expense account.
The company actually includes sales returns and allowances as well as allowance to distributors for advertising in the T-account allowance for returns. Consequently, a portion of the provision for returns is treated as a contra sales account, and the remainder is treated as an expense. This fine distinction is ignored in the case to keep it simple.
Requirement 2The receivables are analyzed using the following approaches:
∑ Examining the trend in provision for doubtful accounts as a percentage of revenues
∑ Comparing the growth in revenues to the growth in receivables
∑ Comparing allowance for doubtful accounts as a percentage of gross accounts receivable with the provision for doubtful accounts as a percentage of revenues
First, let us focus on the provision for doubtful accounts as a percentage of revenues.
1993 1992Revenues (net of provision for returns) $119,598,000 $102,646,000 Provision for doubtful accounts 946,000 3,673,000
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Provision for DA as % of revenues 0.79% 3.58%
Note that the revenue figure used is net of provision for returns. This is because bad debts are likely to be related only to inventory sales that are not expected to be returned by the customers. If gross revenue figures are used, then variations in Provision for doubtful accounts as a percentage of revenue could be due to variations in expected sales returns rather than changes in expected bad debts.
The companyÕs provision for doubtful accounts has decreased substantially from about 3.6% of Revenue to less than 1%. In general, changes in this ratio can indicate changes either in the quality of receivables or earnings management. In this case, it appears that the 1992 higher provision is more likely due to temporarily higher bad debts. Note that the company experienced higher than expected bad debts in 1992 due to a customer bankruptcy and an arbitration case. This information provided in the case was obtained from the management discussion and analysis section. Let us recalculate the ratios after excluding these potentially ÒtransitoryÓ items:
1993 1992Provision for doubtful accounts $946,000 $3,673,000 (-) Chapter 11 customer (2,167,000)(-) Receivable in arbitration ÊÊ(583,000 ) Provision for doubtful accounts (adjusted) $946,000 $ 923,000 Provision for da (adj.) as % of revenues 0.79% 0.90%
Notice that the current year provision is much more comparable to that of last yearÕs after excluding the two specific bad debts. Without any further information, it appears that the company has not substantially revised its bad debt provision during the year. One caveat here is that the change from 0.90% to 0.79% may have a material impact on the bottom line of the company. If profit figures were available, we could calculate the impact on the 1993 net income if the company had maintained the provision at 0.90% as in 1992.
Similar to provision for doubtful accounts, we can also examine the trend in provision for returns:
1993 1992Revenues (net of provision for returns) $119,598,000 $102,646,000Provision for returns 10,942,000 8,863,000 Gross revenues $130,540,000 $111,509,000Prov. for returns as % of gross revenues 8.38% 7.95%
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For provision for returns, the appropriate benchmark is a comparison with gross revenues. Once again, the figures indicate only a minor variation from 1992 to 1993.
A second approach involves comparing percentage of growth in sales with percentage of growth in receivables. If the growth in sales has occurred gradually over the year, then we would expected the two growth rates to be comparable. While disproportionate growth in receivables may indicate potential collection problems, decrease in receivables may suggest declining demand.
Percentage Change from 1992 to 1993% Change in receivables (gross) 11.92%% Change in A/R (-) returns 18.46%% Change in net receivables 24.01%
% Change in gross revenues 17.07%% Change in revenues (net of returns) 16.52%% Change in revenue (-) provision for DA 19.88%
Given so many alternatives, we have to decide whether to compare percentage change in net or gross receivables with percentage change in net or gross revenues. If we use the percentage change in gross receivables as a benchmark for comparison, it appears that the company has efficiently managed its receivables. However, note that while provisions for returns and doubtful accounts immediately decrease the net receivables value, they decrease the gross receivables only when the customers actually return the goods and/or when the bad debts are finally written off. Consequently, when there are large write-offs taking place in a year, you would notice a less than proportionate growth in gross receivables. This is actually what happened for the company.
Write-offs as % of allowance for DA 161.42 ($1,527,000/$946,000)Actual returns as % of allowance for returns 110.04 ($12,041,000/$10,942,000)
Since write-offs were 60% more than the provision for doubtful accounts, the growth in gross receivables appears to be much lower than the growth in sales. However, the change in net receivables (24%) is higher than the growth in gross or net sales. As an analyst, one should conduct further analysis or follow up with the management. Before investigating further, it may be fruitful to get a handle on the materiality of any build-up in receivables, i.e., we should estimate the level of ÒabnormalÓ accounts receivable.
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Balances as of March 311993 1992
Net accounts receivable $ 30,061,000 $24,240,000 Projected net accounts receivable (118%) 28,603,200Abnormal receivable $ 1,457,800
For instance, based on the growth in sales, we might project that the receivables should have grown by around 18%, which is a rough average of the three percentages changes computed above: 17.07%, 16.52%, and 19.88%. Using this assumption, the estimated Òabnormal receivableÓ is $1,457,800. Depending on whether this amount is material or not, additional follow-up action may be taken.
A third approach is to compare the provision for doubtful accounts as a percentage of revenue with the allowance for doubtful accounts as a percentage of receivables.
1993 1992Provision for da (Adj.) as % of revenues 0.79% 0.90%Allowance for da as % of (A/R - returns) 10.62% 14.62%
Obviously, one would expect the allowance percentage to be higher than the provision percentage since more of the delinquent customers are likely to be included in the year-end receivables. The evidence is quite consistent with this conjecture. Moreover, we see a drop in the allowance balance as a percentage of receivables, which is consistent with the larger write-offs experienced during 1993 as a result of higher than usual bad debt provision in 1992.
The following table provides a similar comparison for sales returns:
1993 1992Prov. for returns as % of gross revenues 8.38% 7.95%Allowance for returns as % of A/R 13.53% 18.31%
Unlike bad debts, there is no reason why we should expect larger sales returns on year-end receivables unless the fourth quarter sales have different return privileges compared to the other period sales. Consequently, the larger allowance percentage compared to the provision percentage needs further scrutiny.
